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Startup Valuation, The VC Method_2006

Startup Valuation, The VC Method_2006

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05/09/2014

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Startup Valuation - The VC Method
Published by Ryan Junee September 20th, 2006 in Thoughts.
Anyone from the valley will agree there is a certain buzz in the air right now - a buzz veryreminiscent of the late 90s. Not only does it remind us of the good times, but also of thedangers of getting ‘caught up in the hype’. It seems everyone is all too aware of this becominganother ‘bubble’ - and everyone, including myself, seems to be cautious about valuing newstartups using ‘bubble era’ metrics.So how should one value a startup? It’s obviously a difficult question because the companytypically has no revenues, few assets (apart from people and some IP), and cannot be traded ina market with enough participants (and enough information) to accurately determine a price.This post is a bit of an educational piece for those who wonder how VCs typically value astartup. The method I describe below, is one of the most widely used (often called the ‘VCmethod’). At the very least, this method provides a ballpark figure to start with, which can thenbe adjusted according to a variety of external factors. For more details on the VC Method, seeHBS Note 9-288-006.In describing this method I will start with a simple scenario of a company that takes only oneround of venture financing, and then show how this method can be expanded to handlemulti-stage financing.
Terminal Value
The first thing we need to calculate is a ‘terminal value’ for the company. That is, a value atsome point (say 5 years) in the future. This point may be an expected liquidity event (IPO oracquisition), or failing that should be a point where the company is at least earning a profit. Weneed to
somehow
come up with a value for the company at that point in time. The easiest wayto do this is to look at a comparable company. For example, if a company in the same orsimilar industry was recently acquired or went public, this value can be used as a proxy for theterminal value of the company we are trying to value. Another, perhaps more commonmethod, is to look at price/earnings (PE) ratios for companies in the industry, and use thisalong with expected earnings in the terminal year as shown in the business plan (suitablydiscounted to adjust for EEE - Entrepreneur’s Enthusiasm Error :)Lets make this clearer with an example. Our company, Infelidoo, is expected to earn a $3Mprofit in year 5. Comparable companies in Infelidoo’s industry are trading at PE ratios of around 15. This means Infelidoo’s expected terminal value is $3M x 15 = $45M.Note: this terminal value is
best case
- assuming everything goes right. We will account for thefact that everything doesnt always go right in the discount rate (see below).
The Venture Capitalist’s Required ROI
Lets say our VC is ready to invest in Infelidoo and needs to value the company. The companyneeds $2M to get started - and in this simplified example will need no more cash over the next5 years to reach its goal. Given the risk of this project, the VC decides she needs a 50% annualrate of return on her investment (more on determining the rate of return later).
Startup Valuation - The VC Method at Ryan Sayshttp://blog.ryanjunee.com/2006/09/startup-valuation-the-vc-m...1 sur 57/11/08 10:13
 
This means in year 5 the VC’s investment must be worth (1 + 0.50)
5
x $2M = $15.2M. [That’s just (1 + IRR)
years
x Investment]So, in year 5 the VC expects the company to be worth $45M. Her share of the company mustbe worth $15.2M. Thus her ownership stake in the company must be 15.2/45 = 34%.Note: by taking a 34% stake in the company now, in exchange for $2M, the VC is valuing thecompany at $6M.
The Discount Rate
Above we used a discount rate (rate of return) of 50%, which may have seemed somewhatarbitrary. The discount rate reflects the level of risk in the company (the higher the chance of failure, the higher the discount rate should be). The discount rate should be the sum of:The risk-free ratePremium for market riskPremium for illiquidityPremium for value added by VC (compensation)Premium for “fudge factor” (past experience)Figuring out the exact discount rate to use is more art than science. Some approximateguidelines for discount rates based on the stage of the company are:Seed stage: 80%+Startup: 50-70%First-Stage: 40-60%Second-Stage: 30-50%Bridge/Mezzanine: 20-35%Public Expectations: 15-25%
Multi-Stage Financing
The above example was overly simple because we assumed a single financing was enough totake the company to the point where it became self-sustaining. In reality companies willgenerally take several rounds of financing, and each round dilutes the ownership of existingshareholders. Additionally, option pools need to be reserved for future employees. This affectsthe percentage ownership each investor will have in the terminal year, and thus we must factorthis dilution into the calculations.In essence, we calculate the ’share of the pie’ each investor must have in the terminal year,based on when they make their investment and their required discount rate (using the processoutlined above in each case). Then, we take dilution into account when calculating theownership percentage the investor must take
now
(current ownership %) in order to achive thisterminal percentage ownership (final ownership %).To make this conversion, use the formula:current ownership % = (final ownership %)/(retention %)Retention refers to the amount of ownership that a VC retains, taking into account futuredilution. If there are no subsequent financing rounds then the retention is 100%. If there aresubsequent rounds then it is some smaller number. To calculate the retention %, add up the
Startup Valuation - The VC Method at Ryan Sayshttp://blog.ryanjunee.com/2006/09/startup-valuation-the-vc-m...2 sur 57/11/08 10:13
 
sizes of final percentage ownerships of subsequent investors (the size of their slice of the finalpie), and subtract this from 1. E.g. if there are three investors, and their final shares of the piemust be 15%, 10% and 5% respectively, then the retention % for investor 1 is 1 - (10% + 5%)= 85%. Similarly investor 2’s retention is 95% and investor 3’s is 100%.Note: This is further complicated in the case where an investor also participates in subsequentrounds (which is very often the case). A simple formula wont really help here, and you’ll haveto model the scenario using a spreadsheet.After adjusting for dilution, we know the ownership stake an investor must take in thecompany
now
in exchange for her investment, which implicity places a valuation on thecompany.Well - I think this blog post is now long enough :) I hope this has given any interested readersan insight into the ‘VC method’ of startup valuation. The HBS case note I mentioned at thebeginning contains 54 pages of details, for those interested in reading further.
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12 Responses to “Startup Valuation - The VC Method”
 
Oct 10th, 2006 at 10:08 am
Hi Ryan,I was wondering where you quoted/obtained the discout rate percentages for differentstages of companies? I am doing some research and would appreciate papers or essayswhere I pcould find data that shows this information. 
Oct 13th, 2006 at 4:49 pm
Hi JC,There is an extensive discussion of discount rates in the HBS case I reference in thepost. However, the particular ‘rule of thumb’ numbers I used here were taken from somelecture notes in a class called Technology Venture Formation at Stanford. 
Apr 8th, 2007 at 2:19 am
That’s a whole lot more science than what likely goes on. Try this out for an investor’sperspective. A pretty good reality check on founder’s notion of value.http://foundertransitions.blogspot.com/2007/03/founder-forecasts.htmlL 
Jun 23rd, 2007 at 6:03 am
hi ryan,
1
JC
2
Ryan Junee
3
Les
4
saikiran shetty
Startup Valuation - The VC Method at Ryan Sayshttp://blog.ryanjunee.com/2006/09/startup-valuation-the-vc-m...3 sur 57/11/08 10:13

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